In the meantime, I grow more and more convinced that the government should have just let the financial institutions fail and then compensated by having the Fed pump liquidity into the system at a much higher rate. Don Luskin's recent National Review article identifies problems so far with the bailout which illustrates just how fiendishly difficult it is for a central agency to plan and execute such things:
The other thing I've noticed while investigating the subject, is that the ratio of profits in the financial industry versus all other industries has been steadily rising. Forty years ago (1967), about $1 in $7 of total profits in the United States was made by a firm in the financial industry. Twenty years ago (1987) it was about $1 in $4. Last year (2007), it was almost $1 in $3.
When the Fed sets the precedent that it will, on a weekend when normal market processes aren’t available, hand over a troubled bank to a competitor at a price well below its market value—below even its value in bankruptcy—there’s no incentive to remain a shareholder at all. Long-term shareholders, who ought to be incentivized to stick with banks that run into difficulty, instead receive the message that they should flee at the first sign of trouble lest they be wiped out by the “rescue.” Stronger banks, sovereign-wealth funds, and other private investors that might profitably help a troubled bank by investing in it learn instead to wait for trouble to boil over into crisis, at which time the Fed will practically give the bank away on a Sunday night.
What’s worse, speculators get the message that they can push banks over the brink by shorting their stocks and spreading rumors, driving share prices so low that it becomes prohibitively costly to raise new capital—assuming anyone would dare invest new capital—and the Fed or some other regulator then has no choice but to step in and put them out of their misery. Such speculative attacks work on any bank the government deems “systemically important”—the new way of saying “too big to fail.”
Both the trend (which is pretty smooth) and the direction are worrying to me. The financial industry is an enabler of production, but doesn't actually produce anything of value itself, so to absorb that much of the entire economy's profit incentive seems like a distortion. There may be perfectly good reasons for the trend. For example, the total profit relative to the global economy has probably not increased as much, and the United States does have an oversized share of the global finance business. But still, bailing out the most profitable sector is a bit tough to swallow.